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Thin capitalisation is one of the hot topics of international taxation. A company is generally financed through a mixture of debt and equity. It is said to be thinly capitalised when it is financed through a relatively high level of debt compared to equity. Generally, interest on borrowed capital is a deductible expenditure allowed by every country. Higher the level of debt in a company, higher is the interest and thus, lower will be its taxable profit. Thus the multinational groups prefer debt as more efficient method of finance than equity and structure their financing arrangements accordingly to maximise benefits.

This is perceived to create problems for two classes of people –

• Consumers and creditors bear the solvency risk of the company, which has to repay the bulk of its capital with interest; and

• Revenue authorities, who are concerned about abuse by excessive interest deductions

Companies generally pay interest on capital contribution by parent company or related concerns. The arrangements may be structured in a way that allows the interest to be received in a jurisdiction that either does not tax the interest income, or which subjects such interest to a low tax rate.To counter this strategy, almost all OECD countries and many non-OECD countries as well have, therefore, adopted thin capitalization legislations to protect their tax base.Countries typically tax interest on a source basis. This means that the recipient of the interest (in this case the non-resident lender) will be taxed in the country in which the interest arises (in this case the country of the borrower). i.e. the non-resident recipient of interest will be liable to tax in the country of the affiliate payer. The interest recipient’s tax liability is normally withheld by the paying affiliate, and then paid to the tax authority of the payer.

Thin capitalisation rules typically operate by means of one of two approaches:

a) determining a maximum amount of debt on which deductible interest payments are available; and

b) determining a maximum amount of interest that may be deducted by reference to the ratio of interest (paid or payable) to another variable.

Countries take different approaches to determining the maximum amount of debt that can give rise to deductible interest payments, but there are generally two broad approaches:

i.)The “arm’s length” approachwherein the maximum amount ofallowable debt the amount of debt that a borrower could borrow from an arm’s length lender.

ii.) The “ratio” approach: wherein the maximum amount of debt on which interest may be deducted for tax purposes is established by a pre-determined ratio, such as the ratio of debt to equity. The ratio or ratios used may or may not be intended to reflect an arm’s length position.

Thin capitalisation is considered as a problem from a tax perspective because the returns on equity capital and debt capital are treated differently for tax purposes. Returns to shareholders on equity investments are not deductible for the paying company whereas interest payments on debts are deductible. Thus, many enterprises opt for debt financing over equity. At present, India does not have any Thin Capitalisation Rules. However the Direct Tax Code proposes to introduce this concept.

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Hetvi Sheth
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